The Phillips curve hypothesis suggests there is an inverse relationship between unemployment and inflation, where lower unemployment leads to higher inflation. This relationship was observed in UK data from 1861-1957. The Keynesian explanation is that as aggregate demand increases, output and employment rise along the aggregate supply curve, leading to higher prices and wages. On a graph with inflation on the y-axis and unemployment on the x-axis, this shows as a negatively sloped Phillips curve. The government faces a dilemma of balancing unemployment and inflation levels.

1. PHILLIPS CURVEPHILLIPS CURVE
HYPOTHESISHYPOTHESIS
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. 2
• A.W. Phillips (1958) showed a
statistical relationship between the rate
of growth of money wages and
unemployment in UK 1861 – 1957.
• Data seemed to suggest that fall in
unemployment leads to rise in wage
inflation.
• Or fall in wage inflation leads to
increase in unemployment.
• This is an inverse relationship, and
assumed to be stable.

3. 3
Phillip’s curve
• Can be depicted as
follows:
dw__
_dt__ = h(U) < 0
w
• If prices (p) are linked with wage
movements (w), then the above inequality
can be written as: dp__
_dt__ = h (U) < 0
p
* Price inflation is negatively correlated
with unemployment

4. 4
The Phillip’s curve
0
Unemployment rate %
Rateofwageinflation%
Phillip’s curve
2%
8%
4%
5%

5. 5
Reasons for negative relationship
• As the economy reaches full employment,
competition for labour drives up wage rate.
• Employers will raise prices to maintain profits.
• This is a type of “Cost Push Inflation”,
• Workers’ real wages will not increase.
• So they will again demand a rise in nominal
wage rates.
• Again prices will increase, leading to a wage-
price spiral

6. 6
Keynesian explanation of Phillip’s
curve
0
Price level
Employment or Output
AD1
AD2
AD3
AS
a
b
c
0
Unemployment rate
N0
P0
N1
P1
N20
P2
P0 a’
UN2
P1
b’
UN1
P2 c’
UN0
Phillip’s curve
Inflation rate

7. 7
Keynesian explanation
• In the first panel on the left, AD increases,
leading to increase in Q and employment.
• AS also increases, as long as full
employment is not reached.
• So with increase in Q and N, prices also
increase.
• This is shown by the interaction of AS and
AD curves as “a”, “b” and “c” points.

8. 8
• In the second panel, taking the price levels P0,
P1, and P2,
• Draw the corresponding amounts of
unemployment.
• At P0, employment is low N0, so unemployment
is high, U2.
• As Ps increase, unemployment falls – U1,U0.
• Therefore with increase in inflation,
unemployment decreases.
• This gives the Phillip’s curve, with a negative
slope, showing trade off between inflation and
unemployment.

9. 9
Government policy
• The Phillip’s curve shows that there is a
dilemma faced by government.
• If it reduces unemployment, then it leads
to inflation.
• If it tries to control inflation, unemployment
increases.
• So Government should find the optimum
levels of both employment and inflation.

10. 9
Government policy
• The Phillip’s curve shows that there is a
dilemma faced by government.
• If it reduces unemployment, then it leads
to inflation.
• If it tries to control inflation, unemployment
increases.
• So Government should find the optimum
levels of both employment and inflation.